Unformatted text preview: Property and Capital Market
Real Estate Finance K. S. Maurice Tse
School of Economics and Finance The University of Hong Kong [email protected] Property and Capital Markets
Real estate is a durable capital good. How are its production and price determined in the asset/capital market ? In this market, equilibrium is achieved when Demand to own real estate assets = Supply. Price of houses depends on how many households wish to own units and how many units are available for ownership.
For instance, the value or price of shopping center space depends on how many investors wish to own such space and how many shopping centers there are available to invest in. Everything else held constant, an increase in the demand to own these assets will raise prices, while a greater supply of space will decrease price. Introduction Contd
Supply of new real estate assets derives from the construction sector and depends on the price of those assets relative to the cost of replacing or constructing them. In the long run, the asset market should equate market prices with replacement costs that include the cost of land. In the short run, however, the two may diverge significantly because of the lags and delays that are inherent in the construction process. Introduction Contd
What are the factors that affect the demand for ownership in real estate assets to suddenly increase or decrease?? Are there factors other than simply the price of these assets? The answer is yes. The other factor is the rental income that real estate assets can earn. What is rent? What is Rent
Need to consider the market for the use of real estate. In the market for real estate use of space (usu. Referred to as property market), demand comes from the occupiers of space, whether they be tenants, owners, firms, or households. For firms, space is one of many factors of production
Labor Capital Space Firm’s use of space will depend on
firm’s production technology output levels relative cost of space. What is Rent
For households likewise divide their income into the consumption of many commodities, one of which is space. Household demand for space depends on
income and the cost of occupying that space relative to the cost of other commodities, such as food, clothing, or entertainment. For firms or households, the cost of occupying space is the annual outlay necessary to obtain the use of real estateRENT. For tenants, rent is simply specified in a lease agreement. For owners, rent is defined as the annualized cost associated with the ownership of property. How is Rent Determined
Rent is determined in the “property market” for space use, not in the “asset market” for ownership. In the property market, the supply of space is given from the asset market. Demand for space depends on rent and other exogenous economic factors such as firm production levels, income levels, or the number of households. The role of the property market is to determine a rent level at which the demand for space use clears the supply of space.
For example, when the number of households increases or firms expand production, the demand for space use rises. With quantity of space supply fixed for the moment, rents rise as well. What is the linkage between the asset market and the property market? Refer to the 4-quadrant diagram. Quadrant I: Property Market for Rent Determination
Rent $ II. Asset Market: Valuation I. Property Market: Rent Determination P = R/i D(R,Economy) = S Price $ Stock sq m P = f(C) S = C/δ ΔS = C - δS III. Asset Market: Construction Construction (sq m) IV. Property Market: Stock Adjustment Quadrant I: Property Market for Rent Determination
Demand for space as a function of $ Rent R rents, and the state of the economy. If the economy changes, then the entire curve shifts.
An upward shift occurs with an increase in firms or households (economic growth) and signifies that more space is demanded for the same rent. Economic decline causes a downward shift in the line, with opposite implications. I. Property Market Rent Determination D(R, Economy) = S Equilibrium: D(Rent, Economy) = S Households or firms tend to demand the same quantity of space regardless of rent levels (inelastic demand) the curve is nearly vertical. If space usage is sensitive to rents (elastic demand), then the curve is more horizontal. Stock Sq m Quadrant II: Asset Market for Valuation
Rent $ II. Asset Market: Valuation I. Property Market: Rent Determination P = R/i D(R,Economy) = S Price $ Stock sq m P = f(C) S = C/δ ΔS = C - δS III. Asset Market: Construction Construction (sq m) IV. Property Market: Stock Adjustment Quadrant II: Asset Market for Valuation
II. Asset Market In the property market, the supply of stock is derived from the asset market. Valuation With the rent level determined in the property market for the use of space, P = R/i the asset market will determine the price of space (per unit price of space). If i is the capitalization rate, then the value of an asset with rental income stream R is equal to P = R/i The slope of the valuation curve is the capitalization rate (rent-to-price ratio) for real estate assets. Price $ It represents the current yield that investors require in order to hold real estate assets. What are the components of the capitalization rate?? $ Rent R Components of Capitalization Rate
What are the components that make up the capitalization rate? There are 4 of them:
Long-term interest rate in the economy Expected growth in rent Risks associated with the rental income stream Tax treatment of real estate (if any??). • A higher capitalization rate is represented by a counterclockwise rotation of the valuation curve. • The capitalization rate is taken as exogenous in the sense that it’s based on interest rates and returns in the broader capital market for all assets (stocks, bonds, short-term deposits and so on). Quadrant III: Asset Market for Construction
Rent $ II. Asset Market: Valuation I. Property Market: Rent Determination P = R/i D(R,Economy) = S Price $ Stock sq m P = f(C) S = C/δ ΔS = C - δS III. Asset Market: Construction Construction (sq m) IV. Property Market: Stock Adjustment Quadrant III: Asset Market for Construction
Let C be the level of building activity. Given the asset price determined in the asset market, we can now determine the level of construction as follows: P = f(C) f(C) represents the replacement cost of real estate. Cost of replacement through new construction is assumed to increase with greater building activity (C), and so the construction curve is pointing southwesterly. III. Asset Market Construction P = f(C )
Price $ Minimum dollar value (per unit of space) required to get some level of new development underway. If construction can be initiated at any level with almost the same costs, then the curve will be close to vertical. On the other hand, supply is inelastic when there are construction bottlenecks, land is scarce, and there are other impediments to development. Construction Sq m Quadrant IV: Property Market for Stock Adjustment
Rent $ II. Asset Market: Valuation I. Property Market: Rent Determination P = R/i D(R,Economy) = S Price $ Stock sq m P = f(C) S = C/δ ΔS = C - δS III. Asset Market: Construction Construction (sq m) IV. Property Market: Stock Adjustment Quadrant IV: Property Market for Stock Adjustment
In the property market for stock IV. Property Market adjustment, the annual flow of new Stock Adjustment construction, C, is converted into a long-run stock of real estate space. Stock Sq m The change in the stock, ΔS, in a given period is equal to new construction minus losses from the stock measured by the depreciation (removal) rate, δ: ΔS = C - δ S The curve in this quadrant represents the level of stock (on the horizontal axis) that S = C/δ requires an annual level of construction for replacement just equal to that value on the ΔS = C - δS vertical axis. At that level of stock and the corresponding level of construction, the stock of space will be constant over time, since depreciation will equal new completions. Therefore, Construction sq m ΔS = 0 and S = C/δ . II. Asset Market: Valuation P = R/i Rent $ I. Property Market: Rent Determination D(R,Economy) = S Equilibrium Price $ Stock sq m S = C/δ ΔS = C δS Construction (sq m) IV. Property Market: Stock Adjustment P = f(C) III. Asset Market: Construction The analysis of the property and capital markets can be summed up as follows. Starting with a level of stock of space, the property market determines rents, which are then translated into property prices by the asset market. These asset prices in turn generate new construction, which yields a new level of stock of space in the property market. The property and asset markets are in equilibrium with each other when the starting and ending levels of stock are the same. II. Asset Market: Valuation Rent $ I. Property Market: Rent Determination D(R,Economy) = S Disequilibrium
Price $ P = R/i Stock sq m S = C/δ ΔS = C δS Construction (sq m) IV. Property Market: Stock Adjustment P = f(C) III. Asset Market: Construction If the ending stock differs from the starting stock, then the values of the four variables are not in complete equilibrium, namely, Rent Prices Construction Stock If the starting stock level exceeds the ending level, then rents, prices, and construction must all rise to be in equilibrium. If the starting stock is less than the finishing stock, then rents, prices, and construction must be decreased to be in equilibrium. Summary of Analysis
Exogenous shocks to property market can have different impacts on the operation of the real estate market than exogenous shocks to the asset market.
An increase in demand for space in the property market shifts out the demand curve, increasing rents, which in turn, increases asset prices, construction, and stock of space. A decrease in capitalization rate in the asset market increases the demand for real estate assets, which increases asset prices. Increased asset prices in turn induces more construction, increasing the stock of space and decreasing rents. An increase in construction costs decreases construction levels, which in turn decreases the stock of space, driving rents and assets prices. Example: Office Market
The demand function can be assumed to be
D = E(400 – 10R)
D is demand in square feet E is the number of office workers in the economy (in millions) R is the annual rent per square meter. Given an existing stock of space available and assuming the property market for rent clears, then we have
D=S R = 40 – S/(10E) Example Contd
The cost function ($ per square meter) can reasonably be assumed to be
f(C) = 200 + 5C C is the annual level of new construction in millions of square meter. If these costs are equated to the asset price (per square meter) of office space, then
P = f(C) P = 200 + 5C C = (P-200)/5 Example Contd
The increase each year in stock of office space is the difference between construction and depreciation. Assume that depreciation, δ, is 1% per year. Then
ΔS = C – 0.01S. Given a stable level of construction, the stock that will eventually emerge is
S = C/0.01, the steady state. Modeling the property and asset markets
S R = 40 - 10E R P= i P - 200 C= 5 C S = 0.01 Property Market for Rent Asset Market for Price Asset Market for Construction Property Market for Stock We can solve these four equations iteratively to obtain the equilibrium stock level of space. 800 - 4000i S=E iE + 2 Parameterizing the Model
Suppose there are 10 million office workers in the economy (E =10), Interest/capitalization rate is 5% (i = 0.05), Then long-run stock of office space will be 240 square meters per worker, or 2,400 million square meters. This stock will require that 24 million square meters be constructed each year, and this will require that asset prices equal a replacement cost of $320 per square meter. Rents of $16 annually will sustain such asset prices with a 5% capitalization rate. Questions: In practice, how do we parameterize the four equations above???? End
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This note was uploaded on 09/06/2010 for the course FINA FINA0805 taught by Professor Tse during the Spring '09 term at HKU.
- Spring '09